Pairs trading
Pairs trading is a market-neutral form of mean reversion. Instead of betting on one price, it bets that the gap between two historically linked prices will close.
Drag across the chart to read values
Choosing a pair
Good candidates share the same economic drivers: two oil majors, two banks with similar balance sheets, an ETF and its largest constituents. Correlation alone is not enough. What matters is cointegration, meaning a linear combination of the two prices is stationary.
spreadt = PA,t − β · PB,tThe hedge ratio β is usually estimated with an ordinary least squares regression over a formation period. The Engle–Granger test or the Johansen test checks whether the spread is stationary.
Trading rules
- Enter when the spread's z-score exceeds ±2: sell the expensive leg, buy the cheap leg.
- Exit when the z-score returns to 0.
- Stop out if it reaches ±4, or if a fixed holding period passes without convergence.
Why pairs break
Relationships change: one company is acquired, changes its business mix, or takes on debt. A spread that "always" reverted can trend for years. Re-testing the relationship regularly is part of the strategy, not an optional extra.
Further reading
Gatev, Goetzmann and Rouwenhorst, "Pairs Trading: Performance of a Relative-Value Arbitrage Rule" (Review of Financial Studies, 2006); Ganapathy Vidyamurthy, Pairs Trading: Quantitative Methods and Analysis.
Practice
Three quick tasks. Pick an answer to check it, or open the answer below each task.
Which property matters most when choosing a pair?
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Cointegration. A stationary spread is what makes reversion tradable.
The spread z-score is +2.3. What do you do?
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Sell the expensive leg, buy the cheap one. Short the rich leg and long the cheap leg, expecting convergence.
Stock A is 60, stock B is 40, the hedge ratio is 1.4. What is the spread?
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4. spread = 60 - 1.4 x 40 = 60 - 56 = 4.
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